Editor’s Note: Greg Canavan here. Before you dive into today’s Daily Reckoning from Vern, I wanted to let you know about some exciting changes ahead in 2017.
Starting on Tuesday, 3 January — our first new edition following the holiday break — I will be writing for our sister publication, Money Morning. Along with co-editor Sam Volkering, I’ll continue to call it like I see it, bringing you all of the latest news and investment insights you’ve come to expect.
That means you will no longer see me leading off here at The Daily Reckoning. Don’t worry, though. We’ve got a great editor lined up to fill my shoes here.
To follow me at Money Morning, you can simply click here. We’ll take care of the rest. I hope to see you over at Money Morning in the New Year.
‘What we learn from history is that people don’t learn from history.’
– Warren Buffett
Here’s all the action on overseas markets.
The Dow is languishing. Investors continue to express disappointment in the performance of the US share market.
Interest rates continue to rise.
And the gold price, well it seems almost unstoppable…going from strength to strength.
Oops, sorry. This was the market wrap for early 1980.
In January 1980, gold hit a high of US$850 (from a low of US$36 in 1970).
In April 1980, the US cash rate touched 20% (up from 4.5% in February 1972).
In January 1980, the Dow Jones Index was 860 points (after peaking in January 1966 at 960 points).
Inflation was recorded at 14.7% in April 1980.
After such a long period of established trends — gold up, interest rates rising, share market languishing and inflation going higher — where do you think investors were investing in 1980?
Not when you could put your money in the bank and receive an interest rate of 20% on your hard-earned. Gold was another sure-fire investment. It was an insurance policy against rampant double-digit inflation.
Money piled into cash and gold.
The 15-year loser — the US share market — was very much unloved. And it remained shunned for another two years. The Dow was still languishing around the 860-point level in April 1982.
As they say in the classics, the rest is history.
Gold fell to a low of US$260 in early 2001 and is currently around US$1,140. Interest rates are bumping along under 1%.
And the previously unloved Dow Jones has increased over 20-fold…tantalisingly close to the magical 20000-point mark.
Inflation — the beast the Fed needed to tame 35 years ago — is being given unprecedented levels of stimulus therapy to awaken it from its slumber.
These days, cash is very much unloved.
And gold is having an identity crisis… Am I an inflation hedge? Do I have sufficient industrial usage? Do Chinese and Indian households still love me? Where do I fit into the financial world? Am I to be in the mix of a one-world currency?
Where’s the money going?
Shares…especially those with any sort of yield.
Here’s a quick dashboard on the ‘then and now’ valuation metrics:
|Shiller P/E 10 (cyclically adjusted P/E ratio)||6.7x||28.1x|
|Market cap/GDP (the Buffett Indicator)||32%||119%|
|S&P dividend yield||7.2%||2.0%|
As interest rates have fallen over the past 35 years, market valuations have risen.
Compared to 1982, the current market is certainly not cheap. You could even conclude it’s over-loved, overvalued and overbought.
Are we at a 1982-like turning point…where the investor darling is facing a long period in the wilderness?
On 14 December, 2016, The Wall Street Journal published an article titled:
‘Dow 20000 in 2016, Maybe Again in 2030 – Milestones in the Dow Jones industrials such as 20000 must be viewed in the context of valuation’
The Dow Jones index — the one we all follow — has hit a number of magical milestones in its rich history: 100 points, 1000 points, 10000 points.
Each one of these milestones was seen as a goal point to reach and surpass. Onwards and upwards.
But history shows us the first attempt is most definitely not the final one.
Source: The Wall Street Journal
[Click to enlarge]
The first time the index crossed the 100-point mark, back in 1906, it seemed like a good omen for a roaring bull market. However, the following year, Wall Street experienced its first crash of the 20th century. Nearly two decades later — in the middle of an even greater bull run — the index would leave the century mark behind for good.
A similar pattern held for the 1000 level, first touched in 1966 on an intraday basis at the very tail end of the secular post-war bull market. It wasn’t until 1982 that it was crossed for the final time (we hope). As for 10000, anyone who assumes it’s one for the history books has a lousy memory. The Dow fell 53% between its high in 2007 and its low in 2009. The most recent crossing, early in the current bull market, came more than 11 years after the index first touched 10000.
The current market is on a cyclically adjusted P/E (CAPE) ratio of 28.1…the third highest reading in 135 years of market data. The gold and silver medals for record CAPE ratio readings go to the years 2000 (pre tech wreck) and 1929 (prior to the Great Depression) respectively.
Perhaps history will not repeat itself this time. Perhaps the Dow will sail through the 20000-point level and beyond…without even a glance backwards.
Should this happen, it’ll be the first time in history.
Perhaps it’s different this time.
The following data is sourced from Federal Reserve Economic Data (FRED):
US$ total debt
|$5.5 trillion||$68 trillion||1,230%|
|$3.3 trillion||$18.6 trillion||560%|
Debt to GDP
|230 million||325 million||40%|
Debt growth is completely out of kilter with population and GDP growth.
We know why debt has grown like Topsy…interest rates falling from 20% to zero.
We also know where that debt has gone…into consumption and asset values.
The question is: Can that level of growth be repeated?
Obviously interest rates — the cost of debt — will play a big part in the ability to maintain the love affair with debt.
Where are interest rates headed? According to the good folk at the US Federal Reserve…UP.
On 15 December, 2016, Business Insider published an article titled:
‘Here’s the new Fed dot plot’
‘…The “dot plot,” part of the FOMC’s Summary of Economic Projections released along with the policy decision statement, shows where each participant in the meeting thinks the fed funds rate should be at the end of the year for the next few years and in the longer run.
‘Each of the 17 members of the FOMC anonymously provides their predictions for the target fed funds rate at the end of this year, each of the next few years, and in the longer term. The Fed releases those predictions in a chart that includes a dot for each of the members at their target interest rate level for each time period.
‘While the “dot plot” is not an official policy tool, it provides some insight into how the committee members feel about economic and monetary conditions going forward.’
Here’s a chart of the Fed’s recently released dot plot, showing where interest rates are headed.
Source: Business Insider
[Click to enlarge]
Over the longer run, each of the Fed’s 17 members is projecting an increase in the cash rate. If this turns out to be correct (and given the Fed’s appalling track record, that’s a big ‘if’), it means the cost of debt is going to become more expensive.
Let’s assume the Fed has it wrong and the cash rate flat lines for the next few years (due to an anaemic economy). That still doesn’t make debt cheaper. And cheap debt is what’s needed to replicate the debt growth (the fuel behind economic and asset price growth) of the past 35 years.
The other huge difference between the 1982 market and today is the unknown risk of the derivatives market.
In April 2008, Deutsche Borse Group released a White Paper titled ‘The Global Derivatives Market’:
‘…Around 25 years ago , the derivatives market was small and domestic. Since then it has grown impressively – around 24 percent per year in the last decade – into a sizeable and truly global market with about €457 [$650] trillion of notional amount outstanding.’
In 2002, Warren Buffett famously described derivatives as ‘weapons of mass destruction’.
He repeated this warning again in 2015.
From this year’s annual Berkshire Hathaway shareholders meeting, The Telegraph reported:
‘Emphasising a warning he gave last summer, when he described derivatives as “weapons of mass destruction,” Mr Buffett said a major event such as a cyber attack that shut down the financial markets would trigger “enormous gaps in things you thought might be protected by collateral”.
‘“I regard very large derivative positions as dangerous. We inherited a modest sized position at [Berkshire’s reinsurance vehicle] Gen Re in a benign market and we lost about $400m just trying to unwind it with no pressure on us whatsoever.”
‘“By the way, the accountants blessed that big derivative position as being worth a lot of money. They were only off by, what, a few hundreds of millions,” added Charlie Munger, the vice-chairman of Berkshire.’
No one truly knows the notional amount of outstanding derivatives. Is it US$200 trillion, US$500 trillion or US$1 quadrillion?
Whatever the amount, it’s a seriously big number. To allay concerns over the size of this number, we’re told these position net themselves off. In other words, while one party loses, another party wins. A zero sum game…almost.
In the case of Berkshire Hathaway’s losing position of US$400 million, there was an institution/fund manager who gained US$400 million. Fortunately for the other party, Berkshire Hathaway had the funds to make good on the bet.
But what happens in the event of a Great Depression-type meltdown, in which the opposing party can’t make good on the loss? Then you have two losers. Dominoes start to fall.
The world’s financial markets are far more dangerous than they were in 1982.
The dynamics that propelled the Dow to its record highs are no longer in play. When the only reason to invest in something is because ‘there is no alternative’, then you need to look at the alternatives.
The Dow may well push through the 20000-point barrier. But if history is a guide, I suspect this market will retrace all the gains (and possibly more) from 2009…taking the Dow back below 7000 points.
Big call? Not really.
Ignoring history is an even bigger call.
For The Daily Reckoning
PS: Our colleague Callum Newman recently interviewed former News Corporation and Fairfax journalist Michael West.
You can hear the interview on Callum’s podcast, The Newman Show. As Callum told me, West talks about how newspapers are dead, business journalism is a joke in Australia, and no one takes on big end of town.
It’s sure to be an interesting episode.
To subscribe via iTunes, go here.
To subscribe via Stitcher, go here.